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Financial Market Integration and the International Business Cycle: Theory vs. Reality
- Author Kim Kyunghun
- Date2015-11-20
Is financial market integration associated with business cycle synchronization or divergence? In theory, there should be risk sharing and business cycles move in the opposite direction with respect to a country-specific shock. In reality, however, financial crises led to simultaneous economic downturns and business cycle synchronization, which is the opposite of what theory predicts. We know this from past experience: the 2008 financial crisis and the 1997 Asian financial crisis. What causes this difference between theory and reality is the financial friction that the traditional International Real Business Cycle model overlooks. Financial friction refers to the asymmetric information between lenders and borrowers, and this hinders the efficient allocation of resources across countries. We need to figure out financial friction in more detail, and strive to incorporate it into the model rigorously.
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